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Can International Permit Trading work successfully?

Introduction The idea of an international permit trading under a global cap and trade regime is gaining ground in the wake of efforts to climate change mitigation. The Kyoto Protocol (2007) also recognizes cost minimization through provisions for international trading of emission allowances among countries that accept binding targets. Economists such as Garnaut (2008) and Frankel (2007) advocate this approach as a least cost way to emission reductions. But the critics of this approach such as Cooper (1998; 2000) and Mckibbin and Wilcoxen (1997; 1999; 2006) believe that this approach appears to be successful only in theory and it suffers from many problems in practice, which undermine its usefulness at global level. This essay argues that although international permit trading offers the least cost method to emission reductions, designing a successful and politically acceptable mechanism is difficult to achieve for the successful working of this scheme at the international level.

In an international permit trading scheme, countries adopt a cap under an agreement to treat it as tradable entitlements and trade take place because of the differences in the marginal costs of abatements across countries. Frankel (2007) indicates that developing countries may be able to minimize their cost of emissions reduction by selling permits to the developed world because they can choose low emission technologies while making future investment decision. Similarly, he argues that marginal cost of abatement is higher in the US, Japan and Europe because it is costly for them to replace already installed plants with cleaner technology. Therefore, Frankel (2007) assumes that rich countries will readily buy permits form the developing countries and so the cost of emissions reduction will be lower for both sides under international trading of permits. To prevent costs uncertainties, Frankel (2007) suggests a safety valve mechanism will allow countries to buy allowances at a pre-determined safety valve price. Similarly, Garnaut (2008) points out that international trading in emissions will result in global carbon price which will lead to least cost mitigation of climate.
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Graphical demonstration of cost-effectiveness of international emissions trading when there are no distortions is shown in the figure1 below.

Historical evidence of domestic trade in permits shows tremendous success.

For

example, when amended Clean Air Act was introduced in 1990 in the US which envisaged domestic trading of sulfur emissions, the cost of controlling sulfur emissions was reduced to less than half of the prior costs with an estimated savings of more than US$ 1 billion (Hahn & May 1994). Similarly, costs of emission reductions are likely to fall by 80 per cent as a result of international trading with full participation of developing countries (Edmonds et al. 1992; 1997). Moreover, Frankel (2007) indicates that

international permit trading performs well when run through global models under multiple scenarios and minimizes abatement costs in the longer run. Therefore, the concept of international trading of permits appears to be successful in theory.
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Babiker, Reilly & Viguier (2004)

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However, permit trading for emission reductions at international level suffers from several practical problems contrary to the standard environmental economics textbook analysis. Although the World Bank and IETA (2006) indicate that global carbon market value over ten billion US$ in 2005 and the EU is the most developed market in the world, operationalizing the emissions market at global level is difficult in the presence of distortions (Cooper, 1998; 2001). Lecocq and Capoor (2005) point out that international emissions market is fragmented and trading at regional, national and sub-national is carried out under different rules, which inhibit market convergence leading to increased costs. It is true that diverse domestic and regional systems can be streamlined despite differences in designs but it be will less efficient than an optimized regime at a global level (Baron & Philibert 2005). Moreover, seller countries with considerable surplus allowances of emission rights can exert market power and may affect the global carbon price (Maeda 2003). Thus, international trading of permits may not be successful

because developing countries neither have an appropriate market nor enforcement institutions (Blackman & Harrington 2000).

International trade in permits involves undue and risky reliance on the policy regimes of other countries and may lead to price volatility. McKibbin and Wilcoxen (1999) indicate that permit trading system at international level is likely to collapse in case any major country cheats or withdraw from the agreement. Moreover, there is no guarantee that internationally linked system of permits will be as efficient as the domestic permit trading if the national targets and commitments which jointly determine international price of carbon are not consistent with efficient mitigation action over time (McKibbin and Wilcoxen 2006). Under such a scenario, the international permit price will be subject to great fluctuations. Thus, the loss of control over the domestic carbon price may lead to lack of environmental integrity and purchase of hot air, which undermine the usefulness of such a scheme at global level.

The monitoring of an international trading regime is also problematic in the absence of a global government. Nordhaus (2007) indicates that accurately monitoring of permit
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trading at international level is nearly impossible. He argues that such a system will be susceptible to corruption and rent-seeking attitude because it will involve huge transfers to developing countries where governments are corrupt and inefficient (ibid). This will also lead to resource curse and exchange rate appreciation in developing countries (Mckibbin and Wilcoxen 1999). Moreover, designing an efficient system of side payments through international trading of permits is difficult and require that transfers should be limited only to the incremental costs of mitigations and linked to performance of developing countries with appropriate monitoring mechanism (Carraro 7 Siniscalco 1993, p. 361). Thus, the system trading permits at international level is less likely to succeed without a credible monitoring mechanism.

Apart from monitoring mechanism, transfer of international side payments through international emissions trading require appropriate institutional arrangements such as environmental courts, which do not exist currently (Wiener 2007). Similarly, Mckibbin and Wilcoxen (1999) and McKibbin (1998) indicate that permits would be distributed among countries as envisaged in the treaty and each government would decide how to distribute these permits domestically .Once allocated, these permits could be traded in the world market without any restrictions (ibid, p. 4). However, changes in permit allocations over time may lead to significant financial gains and losses to participating countries, which will invoke political pressure and influence the process of allocation (Mckibbin and Wilcoxen 1999). The allocation of emission allowances across countries either on the basis of population or growth rate poses significant political challenges. Drawing on a rough comparison, Cooper (2000) points out that the average emissions by a typical American family is 2600 tonne per year which is 22 tonne more compared to its per capita allocations. Cooper (2000) estimates that at a carbon price equal to US$100, US$130 billion will be transferred form US to the rest of the world per year, which is ten times more than US total foreign aid expenditure in the year 2000. Furthermore, Cooper (2000) argues that these transfers will be to governments which are indifferent to the welfare of their citizen (p.159). Therefore, huge transfers of wealth to the developing world under international emission trading will not be politically acceptable to rich countries. Thus, despite the
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theoretical advantages of international emissions trading, there are significant institutional and political challenges in the way of materializing this policy at international level (Stavins 1997).

Conclusion The efficiency and fairness of international trading of permits under a global cap and trade regime depends on uniform enforcement of caps and verifiable real emission reductions, which is difficult to achieve in the absence of appropriate monitoring mechanism and other institutional arrangements. Without these preconditions, an international permit trading regime is likely to achieve only limited efficiency gains and may not work as successfully as is generally perceived in theory.

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References Baron, R & Philibert, C 2005, Act locally, trade globally: emissions trading for climate International Energy Agency, Paris. Babiker, M, Reilly, J & Viguier, L, 2004, Is international emissions trading always beneficial? ,The Energy Journal, vol. 25, no. 2, pp.1-24. Blackman, A & Harrington, W 2000, The use of economic incentives in developing countries: lessons from international experience with industrial air pollution, Journal of Environment and Development, vol. 9, no. 1, pp. 5-44. Carraro, C & Siniscalco, D 1993, Strategies for the international protection of the environment, Journal of Public Economics, vol. 52, pp. 309-328. Cooper, R 1998, Towards a real treaty on global warming, Foreign Affairs, vol. 77, pp. 66-79. Cooper, R 2000, International approaches to global climate change, World Bank Research Observer, vol. 15, no. 2, pp. 14572. Edmonds, A, Pitcher, D, Barns, R, Wise, M (1992), Modeling future greenhouse gas emissions: the second generation models, in Lawrence Klein and Fu-chen Lo (eds.), Modeling global climate change, United Nations University Press, Tokyo, pp.295-340. Edmonds, A, Kim, S, McCracken, C, Sands, R, Wise, M 1997, Return to 1990: the cost of mitigation United States carbon emissions in the post-2000 period Working Paper PNNL No 11819, Washington. Frankel, J 2007, Formulas for quantitative emission targets, in Joseph Aldy and Stavins Robert (eds.) Architectures for Agreements: addressing global climate change in the post Kyoto world, Cambridge University Press, pp. 43-50. Garnaut, R 2008, The Garnaut Climate Change Review, Cambridge University Press. Hahn, W & May, A 1994, The behavior of the allowance market: theory and evidence, The Electricity Journal, vol. 7, no. 2, pp. 2837. Lecoq, F & Capoor, K 2005: State and trends of the carbon market 2005. World Bank, Washington. Maeda, A 2003, The emergence of market power in emission rights markets: The role of initial permit distribution, Journal of Regulatory Economics, vol. 24, no. 3, pp. 293-314. McKibbin, W 1998, Global emissions trading: prospects and pitfalls paper presented at APEC Studies Centre conference on Kyoto-the impact on Australia, Melbourne.

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McKibbin, W & Wilcoxen, P 1999, Permit trading under the Kyoto Protocol and beyond, presented at United Nations University Conference on The sustainable future of the global system Tokyo. McKibbin, W & Wilcoxen, P 2006, A credible foundation for long term international cooperation on climate change, Lowy Institute for International Policy Working Paper in International Economics No 1/2006. Nordhaus, W 2007, The challenge of global warming: economic models and environmental policy, viewed on May 21, 2011, <http://nordhaus.econ.yale.edu/dice_mss_091107_public.pdf> Wiener, J 2007, Incentives and meta-architecture in Joseph Aldy & Stavins Robert (eds.), Architectures for Agreement: Addressing global climate change in the post- Kyoto world, Cambridge University Press, New York, pp. 6780. World Bank and International Emission Trading Association, 2006, State and trends of the Carbon Market, Washington.